Tuesday, May 22, 2012

"Reuters Special Report: The algorithmic arms race"

It's the day
after Cambridge physicist Stephen Hawking's 70th birthday party and
David Harding, the head of one of the most successful hedge funds in the
world, is bubbling with talk of black holes.

Given the financial crisis of
the last few years, some might see that as an unwise topic of
conversation for a hedge fund manager. But for Harding, a physicist, the
geekier the better.

The
50-year-old runs Winton Capital, one of a secretive but influential band
of computer-driven hedge funds that bet tens of billions of dollars on
the world's financial markets using algorithms - mathematical
instructions to computers - which consume everything from bond price
moves to rainfall statistics.

For
Harding, whose business attracts mainstream pension investors from the
world over, all of human knowledge is relevant. Rivals are circling, and
data is becoming an increasingly strategic weapon.

Winton's
collection of funds is now worth more than $29 billion. It has returned
14.8 percent a year in its main fund over the past decade - one of the
best records over that period in the UK - and Harding is now likely to
be Britain's highest-paid person, according to this year's Sunday Times
Rich List. It says his wealth almost doubled last year to 800 million
pounds ($1.27 billion).

Funds like his are known in the industry as trend-followers, managed futures
funds or Commodity Trading Advisors (CTAs). Now run almost entirely by
scientists, their 'black box' trading has entered popular culture:
Robert Harris's latest thriller, "The Fear Index", features a fictional
physics expert like Harding and rogue computer code.But
as algorithmic hedge funds have become better known and sucked in
investors' money, returns have started to falter. Managed futures funds
on average have lost money in two of the past three years, gaining just 4
percent in aggregate while the S&P 500 rose 49 percent. An
investment in Winton's main fund would be down 0.75 percent in the first
four months of this year.The
funds are struggling to cope with skittish markets. But they're also
being squeezed by a more mundane fact: their basic techniques aren't so
hard to copy, and can be worked out with a few internet searches.That's
started a fight for market share between big names such as Winton,
Geneva-based BlueTrend and AHL, a giant fund co-founded by Harding
before he set up on his own. To win, a fund needs two things: better
data and smarter ways to use it.

"It's
a bit like a war ... you have to keep on upgrading your armaments,"
said Philip Treleaven, a professor at University College London and head
of its Financial Computing Centre, which works with some of the leading
banks and fund managers. "You're looking for ever-newer algorithms and
so you're using broader sets of data and non-traditional data."

TURTLE RETURNSTo
see how trend-followers aren't all about rocket science, take one of
the forefathers of today's fund managers: Chicago-based trader Richard
Dennis. In the 1980s, he made a bet with a rival that successful traders
could be taught, that it wasn't an innate talent.

As
part of the contest, Dennis taught a breed of traders he called
'Turtles' because he trained them to lock into specific market trends
and ride them, just as turtles ride sea currents. What was important was
to decide on a system and stick with it.

The
approach lends itself to computerized dealing, because in it, trades
are often triggered by the dynamics of the market itself. A classic
example is the moving average. Track the five-day moving average of a
stock and, some traders believe, you should buy where it crosses above
the 30-day average or sell when it falls below.

Such ideas can be converted into an algorithm that tells a computer when and how to trade.The
turtles' edge, like trend-followers today, was in exploiting the
reality that mainstream economic theory doesn't allow for: financial
markets don't behave efficiently, but follow vogues and panics....MUCH MORE